J.P. Morgan Settlement Puts U.S. in Tight Spot

J.P. Morgan CEO James Dimon left the U.S. Justice Department in September after meeting with Attorney General Eric Holder.

Reuters

Will the U.S. government have to refund J.P. Morgan Chase & Co. part of the bank’s expected $13 billion payment over soured mortgage securities?

The question is the biggest stumbling block to completing the record settlement between the bank and the Justice Department and is causing tensions among federal agencies.

Investors, bankers and lawyers are watching the process closely, worried that it could set a bad precedent for the relationship between buyers, regulators and creditors in future deals for troubled banks.

The crux of the issue is whether the government can go after J.P. Morgan for (alleged) sins committed by others. In this case, the fight is over Washington Mutual Inc., the bank-holding company that went bust in September 2008. J.P. Morgan acquired WaMu’s banking operations for a mere $1.9 billion just as the Seattle firm was collapsing.

Any settlement between J.P. Morgan and the Justice Department would include several billion dollars in compensation to investors who lost money on mortgage bonds issued by WaMu.

The WaMu takeover was struck by J.P. Morgan and the Federal Deposit Insurance Corp., the regulator that became the receiver of the failed bank.

In those fraught times, the deal appeared beneficial to both sides. J.P. Morgan paid very little to acquire a major regional bank that gave it a national branch footprint. And the FDIC was able to handle the biggest bank failure in U.S. history without any cost to the fund that insures the nation’s deposits.

But the bad blood between the two camps began before the ink was dry on the sale contract. In fact, the spat centers on what that document says.

According to J.P. Morgan, the contract—known as the “purchase and assumption agreement” or “P&A”—doesn’t cover legal liabilities arising from mortgage securities sold by WaMu. The FDIC and others dispute that.

“If you buy the bank P&A, you get the whole bank, the bad and the good,” Joseph R. Mason, a finance professor at Louisiana State University who has studied bank bankruptcies, told me.

If J.P. Morgan is right, it can try and recoup any payment to the Justice Department related to WaMu bonds by pursuing a pool of $2.7 billion earmarked by the FDIC for the failed bank’s creditors. That, in turn, could force one federal agency to fund part of a landmark settlement negotiated by another agency—a weird and potentially embarrassing situation for the government.

Justice Department officials are aware of this and, according to people familiar with the discussions, are trying to get J.P. Morgan to agree not to go after the FDIC as part of the settlement.

The really bad news: After reading the WaMu purchase agreement and speaking to the two sides, it is apparent that there is no clear-cut answer on whether J.P. Morgan inherited these mortgage liabilities. The document does contain a detailed description of what’s not in the purchase (see page 25 for those scoring this at home), but there is no specific mention of mortgage bonds.

The killer paragraphs, according to the J.P. Morgan side, are those stating that the buyer is not responsible for “claims based on any action or inaction” or “any malfeasance, misfeasance or nonfeasance” by directors, officers or employees of WaMu. In J.P. Morgan’s interpretation, this includes selling mortgage securities.

The stakes are high, even beyond the $13 billion. Wall Street executives and some lawyers warn that if J.P. Morgan is found liable for the WaMu bonds, other banks will think twice before buying failed rivals. “The government will ensure that no bank ever buys another rival in distress,” a top lawyer told me last week.

A total of 475 banks have failed since WaMu and in most cases, another firm acquired part or all of the operations. A lack of buyers would put pressure on the FDIC’s deposit insurance fund, which is paid for by all banks in the country.

But if J.P. Morgan prevails and gets the FDIC to pay, it could wipe out most of the $2.7 billion reserved for bondholders and other WaMu investors. J.P. Morgan critics say such an outcome would have an opposite chilling effect: on investors in teetering banks who have to choose between trusting the FDIC to do its job as a receiver or selling into the market panic.

This is important because the Dodd-Frank law gives the FDIC powers to act as the receivers for all big financial firms. “The precedent completely undermines the FDIC’s ability to act as receiver,” under Dodd-Frank, according to Joshua Rosner, managing director at research consultancy Graham Fisher & Co.

In the aftermath of the WaMu deal, Sheila Bair, then head of the FDIC, said: “Some are coming to Washington for help, others are coming to Washington to help.” But what if some started coming to Washington to sue?